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Europe focused on union rather than breaking up banks

Experts may recommend this week that European banks should separate retail banking from their riskier investment arms to make them safer and soften the impact of financial crises.

But European Union regulators are unlikely to pursue such a radical reform at a time when they are trying to build a banking union to underpin the euro currency and the financial sector.

The European Commission asked the group of experts, led by Bank of Finland Governor Erkki Liikanen, to explore a reform of bank structures in the wake of the 2007 global financial crisis.

Making a separation between retail and high-risk businesses such as trading could be among the proposals Liikanen will make on Tuesday to stop crises in investment banking hurting high street banks and the consumers and small businesses who depend on them.

But European policymakers, struggling to contain the regional debt crisis and associated banking troubles, are already working on creating a banking union that would eventually allow euro zone countries to jointly support banks.

This means there would be little time to pursue complicated structural banking changes and Brussels is likely instead to opt for safeguards such as larger capital reserves for risky business.

"I have doubts on what can be done in the short run given the priority of the banking union," said Nicolas Veron, a regulatory expert with think tank Bruegel.

"Europe faces issues of immediate crisis management. Those issues should be front loaded - this includes the (supervision) package as its adoption is the condition for European Stability Mechanism intervention in the banking sector. This should have absolute priority."

One source familiar with the group's work recently told Reuters that making a separation between retail banking and high-risk business, dubbed "casino" banking by critics, would be part of the proposals although this could change in the final report as opinions have differed on the committee.

The European Commission, which writes the first draft of all regulation before it goes to the bloc's countries and parliament for approval, will not rush its response.

"I would expect that the Commission will need some time to examine the recommendations, and draw policy conclusions from the report," said one EU official.

Earlier this month, the Commission proposed that the European Central Bank (ECB) take charge of supervising banks in the euro zone, as a first step towards creating this union.

The next step would be for a single fund to be created to close down and settle the debts of failed banks and then a comprehensive scheme to protect savers' deposits would be put in place, both politically complicated steps and a far way off.

As well as establishing better control of banks, the union is important because it had been expected to allow the euro zone's rescue fund, the European Stability Mechanism (ESM), to directly inject capital into banks.

SAFEGUARDS

The United States, is pursuing its own structural reforms through the introduction of the Volcker rule, to curb proprietary trading, where banks trade for their own benefit on their own account. Paul Volcker, a former Federal Reserve chairman, had argued against such risks.

Britain chose safeguards for depositors by shielding that part of a bank's business after Royal Bank of Scotland's rush to extend its investment arm resulted in the largest state bailout of the crisis in Europe.

A panel of experts headed by John Vickers, a former chief economist at the Bank of England, recommended that the retail arms of banks be "ring-fenced" by a cushion of extra capital beyond the international norm and with an "independent governance to enforce an arm's length relationship".

The British government has said it will implement his recommendations.

Legally separating investment banking would make it easier for the part of the bank that holds savers' deposits and lend to business to stay open in the event of a crisis, even if other parts of the group go bankrupt, some banking experts say.

It would affect European banks, such as Barclays, Germany's Deutsche Bank or France's BNP Paribas, who combine high street banking alongside riskier trading of stocks, debt and other securities.

But EU officials believe using rules that dictate how much capital banks have to keep to cover the risk of losses or relying on new powers to be granted to the ECB will prove more useful in keeping banks in check in the short term.

Setting aside capital by holding back profits, for example, makes banks less risky for shareholders and host countries.

"One objective (of the report) was to get rid of the implicit guarantee of the taxpayer for banks," said a second person familiar with the committee's work.

Graham Bishop, a consultant on EU regulatory issues, said a scandal over the manipulation of the London interbank offered rate (Libor) would add to pressure to make structural changes.

"There is a feeling that banks have let society down," he said. "Libor is going to further inflame public anger over how banks work."

"The current structure hasn't worked -- If ever there was a moment to try something else, then this would be it."